I’ve posted Entry #317 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Bogle Believes in One Version of “Reversion to the Mean” and Valuation-Informed Indexers Believe in Another.
Juicy Excerpt: Say that you flip a coin 100 times and it comes up heads in 60 of those 100 tosses. Bogle’s understanding of “Reversion to the Mean” is that it is likely that, if you toss the coin another 100 times, the percentage of total times that it comes up heads is likely to be something less than 60 percent. This is inarguably so. This is indeed an Iron Law. This understanding of the phrase is consistent with a belief in an efficient market. A market in which prices follow a random walk will for some time-periods produce results better than the norm but over longer periods of time will produce results that come closer and closer to matching the average long-term return.
The average high temperature in New York City is 60 degrees. The average high temperature in August is 81. Say that you checked the high temperature for every day in August and found that it exceeded the average high on every one of those days. Using Bogle’s understanding of the phrase “Reversion to the Mean,” you would expect to see a total average temperature of something closer to 60 after checking the average high for every day in September. And indeed you would probably see that; the average high in September is 74. But is what you are seeing the same phenomenon that you were seeing with the flipping of the coins?
It is not at all the same phenomenon. Reversion to the Mean as Bogle understands it is an uncaused statistical evening-out process. Reversion to the Mean as Valuation-Informed Indexers understand it is a caused phenomenon, similar to the phenomenon in which temperature readings in August tend to be higher than temperature readings in September. Stock returns are higher in time-periods following the recording of high valuations because it is the purpose of markets to get prices right and so in the long term valuation are always brought back down to fair-value levels. Market prices do not fall in a random-walk pattern in the long term. They move in the direction of fair value for a reason.